PAYBACK TIME; Exotic Deals Put Denver Schools Deeper in Debt

By GRETCHEN MORGENSON

Published: August 6, 2010

In the spring of 2008, the Denver public school system needed to plug a $400 million hole in its pension fund. Bankers at JPMorgan Chase offered what seemed to be a perfect solution.

The bankers said that the school system could raise $750 million in an exotic transaction that would eliminate the pension gap and save tens of millions of dollars annually in debt costs -- money that could be plowed back into Denver's classrooms, starved in recent years for funds.

To members of the Denver Board of Education, it sounded ideal. It was complex, involving several different financial institutions and transactions. But Michael F. Bennet, now a United States senator from Colorado who was superintendent of the school system at the time, and Thomas Boasberg, then the system's chief operating officer, persuaded the seven-person board of the deal's advantages, according to interviews with its members.

Rather than issue a plain-vanilla bond with a fixed interest rate, Denver followed its bankers' suggestions and issued so-called pension certificates with a derivative attached; the debt carried a lower rate but it could also fluctuate if economic conditions changed.

The Denver schools essentially made the same choice some homeowners make: opting for a variable-rate mortgage that offered lower monthly payments, with the risk that they could rise, instead of a conventional, fixed-rate mortgage that offered larger, but unchanging, monthly payments.

The Denver school board unanimously approved the JPMorgan deal and it closed in April 2008, just weeks after a major investment bank, Bear Stearns, failed. In short order, the transaction went awry because of stress in the credit markets, problems with the bond insurer and plummeting interest rates.

Since it struck the deal, the school system has paid $115 million in interest and other fees, at least $25 million more than it originally anticipated.

To avoid mounting expenses, the Denver schools are looking to renegotiate the deal. But to unwind it all, the schools would have to pay the banks $81 million in termination fees, or about 19 percent of its $420 million payroll.

John MacPherson, a former interim executive director of the Denver Public Schools Retirement System, predicts that the 2008 deal will generate big costs to the school system down the road. ''There is no happy ending to this,'' Mr. MacPherson said. ''Hindsight being 20-20, the pension certificates issuance is something that should never have happened.''

A spokesman at JPMorgan, which led the Denver deal, declined to comment. Royal Bank of Canada, which acted as the school system's independent adviser even though it participated in the debt transaction, declined to comment. Denver school officials said that they had agreed to sign a conflict waiver with Royal Bank of Canada.

Denver isn't the only city confronted with budgetary woes aggravated by esoteric financial deals that Wall Street peddled in the years before the credit crisis. Banks have said the deals were appropriate for the issuers and that no one could have predicted the broad financial collapse that put pressure on the transactions.

Still, some municipalities have found such arguments wanting and are pushing back.

Last March, the Los Angeles City Council told its treasurer and city administrative officer to renegotiate interest-rate deals the city had used to try to lower its debt payments with the banks that sold them. ''If they are unwilling to renegotiate, then those financial institutions should be excluded from any future business with the City of Los Angeles,'' noted a report by the City Council.

In Pennsylvania, some school districts have unwound interest-rate deals, and the state's auditor general, Jack Wagner, has urged other issuers to follow suit. ''For the sake of Pennsylvania taxpayers, I call on the other school districts that have entered into similar swaps contracts to get out of these risky agreements as soon as they possibly can,'' he said in a statement in February.

Financial stress from these deals could not come at a worse time for cities, towns and school districts already saddled with high costs and falling revenue. Although it is difficult to tally how many public entities entered into interest-reduction deals, a recent analysis by the Service Employees International Union estimated that over the last two years, state and local governments have paid banks that arranged these transactions $28 billion to get out of the deals, seeking to avoid further crushing payments.

Many transactions remain on public issuers' books. S.E.I.U. estimates that New Jersey would have to pay $536 million to get out of its derivatives contracts, while California faces $234 million in such payments. Chicago is looking at $442 million in termination fees to unwind its transactions, and Philadelphia would have to pay $332 million.

Both Mr. Bennet, whom the White House has praised for his innovative approach to education, and Mr. Boasberg defend the deal they recommended in Denver back in 2008. They say that it has saved the school district $20 million it would have otherwise had to pay to cover the pension shortfall, and they maintain that no one could have predicted the credit crisis of 2008 that elevated the deal's costs.

An article on Friday about the finances of Denver's public school system reported incorrectly an earlier connection between Senator Michael F. Bennet, a former superintendent of the school system, and Thomas Boasberg, the current superintendent. Both once worked in finance in the private sector -- Mr. Bennet for the Anschutz Investment Company and Mr. Boasberg in acquisitions at Level 3 Communications -- but they did not work together. The article also failed to note that Jeannie Kaplan, a former member of the school board who was quoted as criticizing a financial transaction reached during Mr. Bennet's tenure as school superintendent, is a fund-raiser and active supporter of Mr. Bennet's opponent in Colorado's Democratic primary race for the Senate.

Correction: November 5, 2010, Friday

An article on Aug. 6 about the finances of the Denver Public Schools referred imprecisely to a 2008 debt issue that contained an interest-rate swap. While the 2008 deal differed from a security sold by the school system in 2005 and carried more risk than the earlier version, both deals used an interest-rate swap; the 2008 version was not the first time that type of swap was used.